Dispositions of ESPP Stock

The benefit you receive under an employee stock purchase plan is a form
of compensation. You don't have to report compensation income when you
purchase the shares, but you may have to do so when you dispose of the
shares. That's true even if you make a gift of the shares. In fact,
compensation income may appear on your final tax return if you die holding
the shares.

Disqualifying dispositions

The amount of compensation income you report depends on
whether your disposition is a disqualifying disposition.
In general, this is any disposition (sale or gift) unless
both of the following are true:

It is more than a year after the purchase of the shares,
and

It is more than two years after the grant date.

For this purpose, the grant date is normally the
beginning of the offering period. Tax regulations issued in 2009
specify that in some situations the end of the offering
period (when you purchase the shares) will be considered the
grant date. Your company should inform you if this is the case.

Note that holding the shares a year and a day won't
necessarily be long enough to avoid a disqualifying disposition
even if the grant date is the beginning of the offering period.

Example: Your company's ESPP
has a six-month offering period, with the grant date being the
beginning of that period. You buy shares and, 13 months later,
you sell them. This is a disqualifying disposition, even though
you held the shares more than a year, because you didn't hold
the shares until more than two years after the grant date. To
avoid a disqualifying disposition in this situation, you would
have to hold the shares more than 18 months.

If you die holding the shares, your death is treated as a
disposition but not a disqualifying disposition, even if you die
before satisfying the special holding period.

Tax difference

When you hold the shares long enough to avoid a disqualifying
disposition, you don't necessarily avoid having to report
compensation income when you sell the shares. This is a major
difference between ESPP shares and stock you receive from
incentive stock options. You may reduce the amount of
compensation income by holding shares longer, but you don't
necessarily eliminate it.

In fact, because of the quirky way these rules work, it's
even possible to have a situation where you pay less tax on a
disqualifying disposition than you would if you held the shares
longer and made a qualifying sale at the same price. The facts
that present that situation are a little unusual but not
entirely bizarre: the stock has to go down during the offering
period and then go up again before you sell the shares. You
can't always assume it's a good idea to continue holding the
shares until you satisfy the holding period.

There's one situation where it can be very important to
satisfy the holding period, however. If you have a sizable
benefit at the time you purchase the shares but the stock price
declines sharply afterward, you can end up paying tax on phantom
income if you make a disqualifying disposition.

Example: You decide to
contribute $10,000 during an offering period and that turns out
to be a good choice: the stock price rises dramatically, and
because of a lookback provision you're able to buy $25,000 worth
of stock, giving you a $15,000 benefit. You hold onto the stock
only to see the price fall just as dramatically, leaving you
with shares worth just $8,000.

In this situation, a disqualifying sale will require you to
report $15,000 of compensation income. You'll also have a
$17,000 capital loss on the sale, but because of the capital
loss limitation you can deduct only $3,000. Overall, you have an
out-of-pocket loss of $2,000 but you had to pay tax on $12,000
of phantom income ($15,000 of compensation income minus $3,000
of capital loss). By contrast, if you hold the shares long
enough to avoid a disqualifying disposition, you would report no
compensation income in this situation, just a capital loss of
$2,000.

Details on the tax calculation for disqualifying dispositions
are provided here, and details on the
tax calculation for qualifying dispositions are provided
here.